The recession that never was. The late economist John Maynard Keynes famously said, “When the facts change, I change my mind”. These words resonate with investors navigating the ebbs and flows of global financial markets today.
Since mid-2022, the street has been calling for the imminence of a US recession “within 12 months”. The train of thought was simple: High inflation, coupled with rising interest rates, will hit domestic consumption and throw the economy into a tailspin. This assumption was reinforced by the fact that the US Treasury yield curve – historically a harbinger of impending recession – had undergone inversion.
But a year has passed. And the much talked-about recession is still nowhere in sight. We attribute this phenomenon to a confluence of factors happening on the American corporate and households front. On the corporate side of the equation, US earnings have remained strangely resilient despite rising bond yields and this could be attributed to:
On the households front, US domestic consumption has similarly remained resilient and this is due to:
Time for a recalibration of base-case assumptions. Clearly, the street has vastly misinterpreted the strength and underlying resilience of the US economy. Given the prevalence of “Goldilocks” conditions (characterised by moderating inflation and firm economic momentum), the likelihood of a “soft landing” for the US economy is on the rise.
But the fight against inflation is far from over. While inflationary pressure has softened globally, central bankers are now facing the dilemma of navigating between further tightening or putting rates on hold as they await the effects from previous rate hikes.
Rate hikes, meanwhile, are admittedly a blunt and inappropriate instrument to solve today’s inflation challenges. The stubbornly high inflation stemmed not from overheating demand but from global supply chain shocks arising from the Covid-19 pandemic and ongoing Russia-Ukraine crisis. Solving supply shocks is never going to be easy.
In the coming quarter, the shifting macro and geopolitical landscape warrants a recalibration of our base case assumptions and we believe that the following themes will dominate in 4Q23:
Resurgent bond yields and implications for risk assets. Inflation-adjusted bond yields are rising. From the lows of 1.06% on 6 April, the Treasury Inflation-Protected Securities (TIPS) 10Y yield has surged to 1.922% (as of 13 Sep) due to:
Now, with bond yields expected to stay “higher for longer”, a recalibration of the “search for yield” portfolio strategy is necessary.
Since Aug 2022, the blended yield for bonds (consisting of Treasuries and corporate bonds) has superseded the dividend yield for income equities. This suggests that the addition of income equities no longer boosts the overall yield of a portfolio. And therefore from a yield perspective, we prefer bonds over income equities at this part of the market cycle.
China: In dire need of stimulus and policy clarity
“Japanification”: The Chinese great wall of worries. Back in January, confidence on China’s outlook was sky high. But the mood has soured quickly as the market was subsequently dealt a one-two punch. The first was the weaker-than- expected post-pandemic economic reopening. Indeed, initial hopes of strong pent-up demand spurring domestic consumption failed to transpire as Chinese consumers stayed on the sidelines even after the end of the Covid-zero policy.
The fiasco surrounding Country Garden rekindled systemic concerns on the real estate sector (which accounts for roughly one quarter of China’s economy) and the shadow banking space. More crucially, it also put the spotlight on China’s “Japanification” moment as conversations surrounding structural imbalances in the Middle Kingdom took hold. Hopes of massive policy stimulus coming to the rescue, meanwhile, remained elusive. While the PBOC has cut lending rates, these policy measures are not substantial enough to give the economy a massive boost.
Investors are not standing still in the face of these headwinds. De-risking in China-related exposure is gathering steam; since August, a DM index consisting of companies with substantial China exposure has underperformed the broader market by 4.3 %pts (as of 29 Aug). We believe such weakness will persist until substantial monetary/fiscal stimulus and further clarity on government policies are evident.
Cross Assets – Marginal preference for bonds over equities. The latest scoring on our CAA framework suggests that our view on both equities and bonds is broadly Neutral in 4Q, with a slight preference for bonds over equities (in particular dividend stocks).
Fundamentals: The US economy has remained broadly resilient despite tightening financial conditions and this is evident from economic indicators like retail sales and investments. Corporate and household balance sheets are evidently robust enough to absorb the increase in the cost of capital. Inflation, meanwhile, is on an easing path and the likelihood of a sharp spike in inflationary pressure further down the road is low.
On corporate earnings, the proportion of companies reporting positive earnings surprise in the US has improved marginally from 78.5% to c.79.9% in the recent reporting season. That said, the percentage of companies reporting actual earnings growth remains underwhelming at 57.4% as corporate margins pressure persists. Sectors that registered low percentage of earnings growth include Energy (c.21.7%) and Materials (c.27.6%).
Valuation: The gap between US earnings yield and US 10Y Treasury yield has contracted further to 0.324% in 3Q23 (as of 13 Sep) as bond yields continued their upward march during the quarter. Bonds are looking marginally more attractive than equities at this juncture.
Momentum: Inflows into global bonds remained healthy at USD50.9b during the quarter (as of 23 Aug), bringing total flows to USD230.3b YTD. Equities registered inflows of USD36.2b as well and this accounted for close to half of total net inflows for the year.
Equities: Equities on the retreat amid rising bond yields; little differentiation in regional performance expected. Global equities underwent a broad-based retreat in 3Q23 as resurgent bond yields triggered broad-based profit taking. Global equities was down 1.5% (as of 25 Aug) and no region was spared from this selldown. In DM, Japan and Europe underperformed with respective losses of 3.1% and 3.0%. The US managed to outperform marginally with a 0.8% decline, buoyed by strong performance in the energy space.
With bond yields staying “higher for longer”, we expect equity markets to stay subdued in 4Q23 with little differentiation in performance among the key regions. The huge run-up in 2Q23 was predominantly driven by expectations of peak Fed. But the rhetoric at Jackson Hole suggests that this is not the case and hence, the initial enthusiasm for interest-rate sensitive plays will see some tapering in the months ahead.
Within DM, we maintain a preference for US and Japan given stronger macro momentum in these markets. Europe, on the other hand, continues to face recession headwinds as high inflation is forcing households to cut back on consumption.
Our call on Asia ex-Japan continues to underwhelm given overall weakness in China equities. But given the sharp run-up in DM equities, China is looking attractive from a valuation perspective. The yield gap stands at 5.1% and this is 393 bps higher than DM. A strong dose of policy stimulus will rekindle the animal spirits for the market.
Quality plays to outperform as the going gets tough. Despite overall headwinds, there is one silver lining: The outperformance of quality plays. Using US equities as proxy, since August, US quality stocks have outperformed the broader market. This reinforces the view that as the cost of capital rises, companies with strong fundamentals to withstand the challenging environment are preferred among portfolio allocators.
Bonds: Favour quality plays; sweet spot remains with A/BBB credit in 3-5Y duration bucket. The abundance of government bonds offering attractive real yields is crowding out private sector issuance. This inevitably compels corporate issuers to delay their issuance in the hope that the financing could be done at a more favourable interest rate in the future. In this deleveraging phase, investors should stick to IG credit with strong balance sheets that can tide them through periods of volatility and high interest rates. Sweet spot remains with A/BBB credit in the 3-5Y duration bucket.
Meanwhile, we maintain our cautious view on HY credit. The latter possesses substantially lower duration compared to IG and this translates to higher refinancing risks in the years ahead. We expect HY spreads to widen next year as default risks mount in a high interest rates environment. Fund flows data from EPFR Global reinforces our view. On a YTD basis, fund inflows into IG credit totalled USD41.2b (as of 23 Aug) while HY credit registered outflows of USD9.1b.
Alternatives: Seek opportunities in PE secondaries and private credit; gain exposure to gold as portfolio risk diversifier. Despite moderating company valuations and bleak exit prospects, we see opportunities in the private equity secondaries market space. The same can be said for private credit. While the latter faces competition from attractive bond yields in public markets, portfolios with exposure to opportunistic strategies will still provide diversification benefits as they allow investors to hedge against economic headwinds through dislocations and defaults.
On gold, we maintain our constructive view with a 12M target price of USD2,050/oz. The peaking of Fed monetary tightening cycle and potential rate cuts starting in 2H24 are tailwinds for the precious metal. Apart from ETFs, we also see rising demand from central banks as simmering geopolitical uncertainties fuel the de-dollarisation narrative. Gain exposure to gold as a portfolio risk diversifier given its low correlation with major asset classes, in particular, global equities.
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